Econ 101: Origin of Money and Banking

In the article about Interest Rates and Credit, I mentioned that I would attempt to explain in a later article how the Federal Reserve Bank raises or lowers interest rates. That article is coming, but I believe the explanation requires a bit of background first. I’ll start with money.

Money is defined in part as a “medium of exchange,” which is a fancy way of saying “the thing you swap with folks to get the things you want.” The process of a thing becoming money goes like this: You’ve got something I want, say a bucket of fried chicken, but I don’t have anything of comparable value that you want. Maybe you’re willing to trade the chicken bucket for my car, but this seems excessive to me, even though I do want to get rid of the car. You also like shiny things, however, such as gold. I know a guy who will give me enough gold in exchange for my car to make me feel like I’ve gotten a good deal, say 100 pieces, so I make that trade with my guy. I now have 100 pieces of gold to carry around. You’d be happy to get 2 pieces of gold for your chicken bucket, so we make that trade, and now I’ve got my chicken (plus 98 pieces of gold) and you’ve got your shiny things. The gold in this example is the “medium of exchange.” My guy gave some gold to me to get the car, and I gave some to you to get the crispy golden-brown goodness in its convenient storage vessel. All this seems really obvious because we’re so used to it, but if I hadn’t known my guy would trade in gold and that you would also trade in gold, I’d have had to remain chickenless.

As an object becomes more and more accepted for use, not for its “use value” but for its “exchange value,” that object becomes the money. As money becomes more abundant and widely used, people begin to want to store it someplace safe, and gold (or silver or whatever) warehouses spring up to meet that demand for safe storage. These warehouses take account of how much money each customer is storing with them and issue those customers receipts. Now if I want to trade some amount of money for a chicken bucket, I have to go to the warehouse, show them my receipt, and withdraw the money while they make a note on my account. I then go to the chicken bucket supplier and give them the money.

To save time and inconvenience, I might just give the receipt to the bucketeer in the first place, and let him go to the warehouse to get the money. This is easier to do if the warehouse issues multiple receipts or something like tickets for certain amounts of money, so that my total “receipt” is really just a collection of tickets in various amounts whose total matches the total of my account at the warehouse. That way, I only have to hand the chicken provider a few of those tickets, rather than marking through my receipt to show the amount for which I’m authorizing withdrawal. Over time, these tickets begin to be seen as being “as good as” the real money, at which point people just trade the tickets since they act as a claim on the real thing in a real warehouse somewhere. People know they could get the real money out if they wanted or needed to, but as long as sellers will accept the claim on the money, there’s no need to carry around the real thing.

This is, conceptually anyway, the origin of money and banking, with a bit of the evolution of money thrown in. In the next post, I’ll discuss a bit about how banking has evolved, including the promised Federal Reserve discussion and the evolution of the concept of inflation. I’ll try not to write that one while I’m hungry.